Is Facebook Way Ahead of Itself?

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Facebook's stock has sunk from the IPO price of $38 a share to the low $20's. This has gotten a lot of people talking about whether or not this makes the company a good buy. It's certainly cheaper than it was but is it cheap enough based on some sort of realistic estimate of its future cash flows? This isn't the easiest company to value since it's a new company in a new industry (targeted advertising), has no direct peer, and is growing incredibly fast. Usually I run valuations on stodgier companies.

Aswath Damodaran, a professor at the NYU Stern School of Business and incredibly generous teacher of valuation techniques, has been following Facebook and posting his ideas as to its valuation. He values the company at around $24, which is a reduction from his first cut valuation of around $28. Damodaran reduced his initial valuation after reading the first 10-Q since the IPO came out, reducing his near term revenue growth rates. Morningstar also covers the company, valuing it higher at around $32.

Both Damodaran and Morningstar ran into the same challenge of estimating revenue growth and operating margins over the next 10 years for such a young, high growth company. Both valuations relate Facebook's possible revenue and operating margin trajectory to Google's, with Damodaran more explicitly grafting Google's historical revenue growth curve onto Facebook's current revenues, growing Facebook's current revenue of about $4 billion to the $40 billion Google makes now over the next ten years. Both valuations have the current stellar 50%-ish operating margin compress over time down to the low to mid 30% range as the company gets bigger, again putting it about in line with Google's current operating margin.

I ran a valuation similar to what Damodaran and Morningstar did for my first cut valuation. Like they did, I assumed that in ten years Facebook would look roughly similar to Google. This isn't completely outlandish. Both companies make money by selling internet advertising on a site so useful/popular that it commands the attention of hundreds of millions of users. In addition, both Google and Facebook know enough about you to run targeted ads, customized to your search and/or user information. However, saying that Facebook will become as successful as Google in about the same timeline as Google did is a bold assumption: Google is one of the most successful companies on the planet. You have to keep that in mind. There is a lot of rosiness baked into the basic valuation assumption!

Let's assume Facebook would be making about what Google does now in ten years, about $40 billion in revenue, ten times what Facebook makes now. As a point of reference, it took Google about eight years to grow revenue from $4 billion to $40 billion, I assume operating margins reduced from about 40% down to 32% to match Google, then matched working capital (which is huge now what with the cash raised from the IPO) down to match Google's, as well as brought down the high capex spending over time to match what Google shells out these days. For revenue growth I looked at both how Facebook was growing recently and how much growth it would take to grow revenue to $40 billion in 10 years. I ended up keeping revenue growth at 35% for the first 5 years and then ramping that down to 8% by year 10, then used 3% terminal growth. Essentially I turned Facebook into Google over ten years. I discounted the future cash flows by 10%.

I used a diluted share count of 2.65 billion, which is the latest figure I read from a fairly accurate source (Barron's this weekend). The share count changes a lot as we bounce through the restricted share unit/stock option lockup periods. For example, the 10-Q, which was just put out July 31 (just two months ago), lists the share count at 1.9 billion shares. Morningstar lists the share count at 2.5 billion shares. Yahoo Finance is way off at 2.14 billion shares.

Discounting those cash flows I ended up with a share value at around $25 a share. That doesn't get me too excited. Basically Facebook has to hit a home run over the next 10 years to be worth about what it's trading at now in the low $20's. Given the uncertainty around Facebook's revenue growth curve I'd want to buy at 40% discount to my valuation, which would put my buy price (if I were interested, which I'm not) at around $15.

Speaking of Barron's, the cover page article this weekend was on Facebook. They're bearish on Facebook, saying it might be worth only $15. Typical of Barron's valuations, few details are offered behind the valuation estimate. Compared to Damodaran's thorough work this all that Barron's said with respect to its valuation technique:

What are the shares worth? Perhaps only $15. That would be roughly 24 times projected 2013 profit and six times estimated 2013 revenue of $6 billion, still no bargain price. Wall Street's consensus estimate for 2013 shows earnings rising 31%, to 63 cents a share.

Putting Facebook's revenue trend or margin trendline next to Google's is absurd. Google's model allowed millions of advertisers to participate with almost no overhead cost structure. Bidding against each other, Google's advertisers maximize revenue for The search giant, and more to the point, most of them pay up front!

By contrast, Facebook is in the traditional advertising business, convincing WalMart to include some banner ads on the site, and dreaming up ways to make users "like" a particular page, site, or deal.

Perhaps someday Facebook will figure up a way to do the frictionless advertising that pours so many nickels, dimes, and quarters into Google's pockets, but for the time being, they're not close. Every sale requires a sales call, or four, and dealing with ad agencies and large corporations they pay in arrears, usually discounted, and in far fewer chunks than what Google gets. Facebook has fewer targets, has almost infinitely higher cost of sales, and gets paid later. No comparison, except perhaps they both show up on your computer screen.

I might not go so far as to say it's absurd, but I did say it's a very rosy scenario to do so. My point in the valuation was that I couldn't make a good case for investing in it in the low $20's even when I set Facebook up to hit a home run (i.e. match Google's growth rates).

Who knows. It may monetize mobile and revenue growth might expand much more than 35% in the first few years. But that's even more optimistic than my optimistic scenario.

Let's assume Facebook would be making about what Google does now in ten years, about $40 billion in revenue, ten times what Facebook makes now

I have to say that is one big assumption. I could think of a ton of companies wanting to make that. But wanting and doing are two different things. FB and GOOG are simply two different companies. People go to Google to search, so ads work. People go to FB to chat and play.

You would have to devise one heck of an advertising vehicle to steer FB users to the ads. And I don't think Zuckerberg has a clue as to how to do that.

Absent some blowout numbers at its next earnings report, this thing could hit low teen-single digits as those lockups expire and people start cashing out.